Financial Markets and the Economy
Read this chapter to build a foundation for understanding financial markets. The first section discusses the bonds and foreign exchange markets and the way they are connected through the interest rate. The second section builds the model of the money market and connects it to the other financial markets. Pay attention to how the connection is made between the financial markets and the overall economy by showing the effects on the equilibrium real GDP and the price level, using the model of aggregate demand and supply.
Demand, Supply, and Equilibrium in the Money Market
The Supply of Money
The supply curve of money shows the
relationship between the quantity of money supplied and the market
interest rate, all other determinants of supply unchanged. We have
learned that the Fed, through its open-market operations, determines the
total quantity of reserves in the banking system. We shall assume that
banks increase the money supply in fixed proportion to their reserves.
Because the quantity of reserves is determined by Federal Reserve
policy, we draw the supply curve of money in Figure 10.7 "The Supply
Curve of Money" as a vertical line, determined by the Fed's monetary
policies. In drawing the supply curve of money as a vertical line, we
are assuming the money supply does not depend on the interest rate.
Changing the quantity of reserves and hence the money supply is an
example of monetary policy.
Figure 10.7 The Supply Curve of Money
We assume that the quantity of money supplied in the economy is determined as a fixed multiple of the quantity of bank reserves, which is determined by the Fed. The supply curve of money is a vertical line at that quantity.